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Also, check out: "Up on Rumors, Down on Facts," "A Solid Quarter," "Now IBM Is Even 'Officially' Spineless", "Where Armonk Meets Wall Street, Greed Breeds Incest", "Some Insiders Cashed in on IBM Stock Buybacks", "Louis XIX of Armonk", "Wag the Big Blue Dog", "the new blue"  

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Analysis of IBM Fourth Quarter Business Results

Up on Rumors; Down on Facts

Surge in Software Boosts Profits; Great Quarter for IBM Services

WESTERN AUSTRALIA, Jan. 22 - IBM's fourth quarter net earnings, which the company released on Thursday after the market closed, slightly exceeded the Wall Street analysts' consensus ($2.47 versus $2.45 per share). So look for the IBM stock to take a dive on Friday.

Why? Because overhyped and overpriced stocks, like the Big Blue's, tend to trade UP on rumors, and trade DOWN on facts.

This week, for example, IBM shares were up by more than 6% as the investors' anticipated much better-than-expected fourth quarter results. Now that the actual figures have only slightly exceeded the analysts' estimates, some of the hot air is likely to be released out of the Big Blue balloon. Which would still leave plenty of it left.

Based on Thursday closing price of $197, IBM shares now consist of $19.4 billion of tangible equity and $164 billion of hot air, or market "fluff" as we call it. That's a "fluff ratio" of 9.4, up 81% over 1997; which was up 40% over 1996; which was up 59% over 1995 - the first year of IBM's share repurchases.

So while IBM's pretax profits have been flat ($9 billion) during the last three years; and while its revenues grew at the meager 3% and 4% annual rates respectively, the Big Blue's stock price went through the roof, principally on account of its $25 billion-and-counting stock buybacks ($6.9 billion and $7.1 billion in 1998 and 1997 respectively). That's more than the company had spent on all capital investments and dividends - combined. And considerably more than about $5 billion per year which IBM has been spending on research and development (R&D).

Given that most of the stock buyback billions ended up in Wall Street's pockets, IBM effectively bought $164 billion of "fluff" (Wall Street recommendations) for about $25 billion of real money.

On the surface, it looks like a cool trade. As long as the stockmarket is looking cool, that is. For, this illusion of prosperity has been boosted by investment cashflows being repatriated from the various overseas crises (Southeast Asia, Russia, Brazil…). Once such positive cashflows are reversed, which is bound to happen for various reasons we had explained in the past, suddenly the "fluff" will start to look like "fluff," and not like tens of billions of dollars of real money which IBM has spent creating the market's inflated perception of its success.

Actual Fourth Quarter Results

But what about IBM's real fourth quarter results? Don't they matter? They do. But not so much to the stock price, as seen above.

As we said in the opening paragraph, IBM beat analysts' expectations for the fourth quarter. And it exceeded our forecast by an even greater margin. That was mostly due to a surge in IBM's fourth quarter software profitability (75.2% gross margin; up from 71.8% a year ago), as well as a more moderate increases in the gross margins of its declining maintenance business.

These gains were partially offset by the decline in the hardware gross profit (down over 10%, or 3.3 margin points).

Aided by the declining U.S. dollar, IBM also did a good job of keeping the lid on selling, general and administrative (SG&A) expenses. They ended up at just over $5 billion, virtually flat with the 1997 figure, but down one point as percent of revenue to 20.2%. A slight reduction (1.3%) of IBM's fourth quarter R&D expenses also aided its profitability.









Analysis of 4Q Pretax Profit

By the time all these expenses are distributed to the five IBM business segments, some odd conclusions follow:

IBM's biggest business segment (hardware, 4Q revenue $11.3 billion, down 2% from 4Q97) was its least profitable. We estimate that hardware generated a pretax margin of only 6%, down by about 22% from the year before.

Another IBM declining business segment (maintenance, 4Q revenue $1.5 billion, down 3% from 4Q97), was its most profitable. We estimate that maintenance had a pretax margin of 44%, up 25% from the year before.

This means that IBM got about as much pretax profit from the $1.5 billion of maintenance revenue as it did from its $11.3 billion hardware business! Which also goes to show us how much deadwood IBM's is carrying in its hardware portfolio.

IBM's most profitable business in absolute terms was software ($4.1 billion 4Q revenue, up 9% from 4Q97). With a pretax margin of 25%, we estimate that software generated just over $1 billion in pretax profit, up 33% from the year before.

This means that a business segment which accounted for only 16% of IBM revenues represented 31% of its pretax profits.

IBM's fastest growing business segment - services ($7.1 billion 4Q revenue, up 20% from 4Q97) had a pretax margin of just over 8%. That's actually above the top five IT services leaders' pretax profit average (6.6% in 1997), but is nevertheless fairly low relative to software or maintenance businesses, for example.

As a result, IBM services, which accounted for a record 28% share of IBM's fourth quarter revenue, only represented about 18% of its pretax profit. And in absolute terms, IBM's "rising star's" (services) pretax profit was LESS than that of both of its "shooting stars" (the declining hardware and maintenance) businesses.

For the full fiscal year 1998, the relative pretax figures would vary, of course, but our overall conclusions are the same as that for the fourth quarter:

IBM's fastest growing business (services) is its second least profitable; its biggest segment (hardware) is its least profitable; and its fastest eroding business (maintenance) is its most profitable.

For Wall Street to give a standing ovation to a company with such business fundamentals, can only mean one of three things:

(1) Either Wall Street doesn't understand IBM business fundamentals;

(2) Or Wall Street understands, but doesn't care about IBM business fundamentals;

(3) Or Wall Street doesn't understand, nor cares about IBM business fundamentals.

Feel free to put your check mark opposite one of the three options.

For our money, we would tick off (2). The "fluff merchants" do not usually lack the smarts; only the morals and business integrity.

Segment Analysis

Services. As for IBM business segments, the Big Blue's Global Services operation certainly had a stellar quarter: $9 billion in new business - about as much as its next largest competitor, EDS, closed in the first three quarters of the year. IBM claimed 11 "megadeal" wins in the quarter spread across seven industries. Six of those were outside the U.S.; three were extensions of existing services contracts.

For the full fiscal year 1998, IBM Global Services closed $33 billion in new contracts, including 38 "megadeals." That's more than double the amount of new contract sales that any IT services company, except for IBM, has closed in history.

As a result, IBM is estimated to have over $50 billion in its services backlog. Just how profitable these deals are, however, time will tell. As you saw from the earlier fourth quarter analysis, services were the second LEAST profitable part of IBM's business, right after hardware.

Geography. Europe and North America were tied as IBM's best geographic regions, each reporting a 9% growth in constant currencies. In terms of the reported figures, Europe grew by 13%, by far the best year the Old Continent has had since before the Gulf War.

IBM's Latin American business, on the other hand, was the pitts - declining by 22% since the year before, or by 19% in constant currency.

The Latin American regional financial problems were a part of the reason for IBM's business downturn, especially in Brazil, which accounts for 40% of IBM's 7% of worldwide business which Latin America represents. But corruption allegation involving IBM executives in Argentina and Mexico, for example, didn't help the Big Blue's cause, either.

As for the Asia/Pacific region, IBM's revenues there dropped 3% as reported, or 6% in constant currency.

Research & Development

During Thursday's teleconference with analysts, IBM's CFO, Doug Maine, boasted about his company's "significant patent activity."

If business leadership were a science; if quantity were a substitute for quality; if inventing a better mousetrap were a guarantee of success… the Big Blue would still rule the information technology world. And a scientist, rather than an Ivy League Old Boy, would run IBM.

As it turns out, however, none of the above postulates are true.

In 1998, for the sixth year in a row, IBM was awarded more U.S. patents than any technology company in the world. Yet, as you saw above, 1998 also marked the fifth consecutive year of declining equity for its shareholders. Since 1992, the last year of the John Akers era, IBM's equity has declined by $8 billion. It is down by $23 billion since 1990, the peak year in IBM's recent business performance.

A closer look at the top 10 U.S. patent award winners in 1998 reveals that IBM is actually the champion of industrial era relics. The absence from the top 10 list of Intel, Microsoft, Sun Microsystems or Netscape, some of the trendsetters in the last six years, underscores the irrelevance of patent statistics as an indicator of business success and market power. Today's customers want turn-key solutions, not black boxes or better mousetraps.










Even IBM said so. However inadvertently. "Our patent success over the past six years is directly contributing to IBM's growth…," said Nick Donofrio, IBM's chief technology officer, in a release. "More than one-third of the technologies represented by these patents already show up in products…" Which means that almost two-thirds of these inventions have NOT made it even into IBM's own products.

No wonder Jim Cannavino, a former IBM executive and the company's chief strategist in the 1993-1994 period, was able to eliminate over $800 million of the Big Blue's research and development budget in his first six months on the job - without canceling a single product. Yet such pruning of deadwood in IBM's $5 billion annual R&D budget would have wiped out the 1993 R&D expenses of Microsoft, Compaq, Dell and Oracle - combined! And it was about three-times greater than the current R&D spending of AOL and Netscape - also combined!

So much Big Blue deadwood; so little grassroots growth…

And even if IBM's new technology eventually did make it into its products, it was still no guarantee of business success.

  • Anyone still remember the PC Jr.? Born in late 1983. Died in 1984. A case of a PC "crib death."
  • Or the OS/2 Warp, IBM Ivy Leaguer chairman's firstborn? Died in 1996. Due to parental neglect. Yet still carried on the books as a living dead. Thus no murder charges filed.
  • Or the PowerPC, IBM's power trip launched in 1991. There is not even a gravestone at the IBM Web site marking this Big Blue brainchild's death. Only the big write-offs, buried deep inside Armonk's consolidated financial statements, attest as to its existence. Yet, back in 1993, PowerPC was touted as a bigger than life challenge to the Wintel juggernauts.
  • Or the Net PC, a stillborn, fathered jointly (don't ask how) by IBM's Lou Gerstner and by Oracle's Larry Ellison and Sun's Scott McNealy. Mother unknown. IBM even formed a Net PC Division in the fall of 1996 as this baby's bassinet. Two years later, not only the baby, but even the bassinet is missing.
  • Or Taligent? Tally what? We hear you. Taligent was also launched during IBM's power trip in 1991. A joint IBM-Apple (and later HP) "object-oriented" software challenge to Wintel. But the marketplace "objected" to its orientation.

Ultimately, however, the earth shifted not only under IBM, but also under "Wintel." A mouse that roared, and one which is now still threatening to devour the industrial era rats, is actually the one next to your keyboard. And there is no known way of trapping such mice. Yet.

Happy bargain hunting!

Bob Djurdjevic

Additional Charts

  • IBM's 4Q98 Pretax Profit Shares (last 3 years)
  • IBM's 4Q98 Gross Profit Shares (last 3 years)
  • IBM Stock Buybacks (1Q95 - 4Q98)
  • IBM Equity Down $4B
  • IBM's Quarterly Net Profit (Loss) (1990-1998)
  • IBM's Negative Cashflows (last 3 years)
  • IBM International Revenues (North America, Europe, Asia/Pacific, Latin America)


  • IBM Income Statement - 4Q98 (last 3 years)
  • IBM Pretax Profitability - 4Q98 (last 3 years)
  • IBM '98-'99 Revenue/Earnings Forecast

Are you eager to learn more? If so, please call 602/824-8111.

Also check out Annex Bulletins "Wag the Big Blue Dog" and "the new blue."

Volume XV, No. 99-02
January 22, 1999

Editor: Bob Djurdjevic
Published by: Annex Research;

5110 North 40th Street,      Phoenix, Arizona 85018
TEL: (602) 824-8111        FAX:

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